How Much Disaster Can Gold Hedge?

Lying somewhere between meme and cliché is the idea that when the going gets tough, the smart buy gold. Gold has had a special hold on the minds of many investors for centuries, if not millennia, offering the promise of being the one asset that will never go to zero, and the one medium of exchange that other people will always accept in trade. While these notions are basically true, investors would do well to consider just how much disaster they can really hedge by buying gold.TUTORIAL: Commodities: Gold

Forget InflationWhenever it is time to debate the merits of gold, it is only a matter of time before someone mentions the iffy correlation between gold and inflation. The history of gold versus inflation looks a lot like a bungee cord - years and years go by and nothing seems to be happening, until there's a point of release and the price of gold rockets up.

For instance, it took 28 years for the prior peak price in gold to be re-attained. Gold spent most of the '80s and '90s declining even though inflation was technically continuing to increase. Likewise, there is now the growing belief that gold's current price is already pricing in decades of inflation to come (suggesting that the price of gold would be flat or down).

To be fair, this argument has a few flaws. First, the CPI is the most common inflation proxy used in comparison to gold and it has some significant flaws. Also, it is not constructed to be a forward-looking indicator. Second, the end of the gold standard 1971 is an important detail - it reduces the amount of truly comparable data available and makes post-1971 conclusions somewhat risky as there have been really just two major economic panics in that time. (For related reading, see Gold: The Other Currency.)

How Valuable Is It in a Real Disaster?Take the fears of the most extreme gold bugs all the way to "10" and the virtues of gold do not really hold up very well. First of all, one of the reasons to buy gold is that it has "real value" in a time when paper money could be rendered worthless, but how many people out there are capable of assaying gold? Gold has been debased and counterfeited for millennia and fake gold is not worth much more than defaulted paper money.

Investors should also remember that governments around the world have seized the gold of their citizens in times of crisis. Those who think that it couldn't happen in the U.S. or it would be over their dead bodies should refer to Gold Reserve Act of 1934 - the act that gave the U.S. government the power to seize gold at a value determined by the people doing the seizing. (For related reading, see What Was The Gold Reserve Act?)

To be even more catty, gold has a few major problems when it comes to real crisis - it is heavy, it cannot be eaten, it cannot be worn and it cannot be used as shelter. As far as using it as a medium of exchange once the government - and law and order - has collapsed doesn't work. If the government collapses and there's widespread chaos, gold is not going to be worth much absent the willpower and hardware to defend it. In other words, if I have a gun and you have gold, I'll soon have my gun and your gold. The value of gold to the regular person in a situation of total disaster is very much uncertain - the idea of people calmly going about their business and buying goods and services with gold coins presumes quite a bit of order and infrastructure staying in place.

What Gold IsGood ForJust because gold is not a perfect inflation hedge, nor an insurance policy against disaster, does not mean that it has no value and no use. Gold has inherent value in that it does not simultaneously represent one party's asset and another's liability. It also happens to be an excellent trade on fear. While gold's movements are very unpredictable over short periods of time, outperformance seems to correlate strongly with people feeling bad or nervous about economic and political conditions in their country.

It may not be widely remembered now, but in addition to major inflation issues in the late 1970s and early 1980s, there was quite a lot of fear about the state of the U.S., the quality of its leadership and competitiveness, and whether the country could continue to pay it bills. If that sounds familiar, it's no coincidence. Then as now, people did not have confidence in the U.S. government and could not envision how the U.S. would stay globally competitive. Consequently, many people dumped stocks and bonds in favor of gold. Gold set record prices that have only recently been surmounted.

Banks can fail and governments can run the printing presses all day and night, but there is only so much gold in the world. That is a powerful security blanket to hold onto while waiting for the next economic turnaround and the next technological revolution.

The Bottom LineFor investors who understand the psychology of the fear trade, and who can appreciate that gold is one of the only financial assets that becomes more attractive as people feel worse about the economy, gold is a great investment vehicle. For investors who believe that gold is a no-brainer hedge against inflation or proof that they can survive the collapse of Western Civilization, gold is a pretty lousy instrument.

Like any other financial asset, gold is worth most when there is an orderly market of willing buyers and sellers. Disasters are infamous for being decidedly disorderly and, as political collapses in recent decades have shown all too well, the rule of the gun is more common than the rule of the gold when the center no longer holds.

There are plenty of reasons to be skeptical and disillusioned with western governments today, and it is all but certain that there is a day of reckoning to come as debts, unfunded obligations, overextended money supplies and insufficient tax bases all come home to roost. Investors should ask how much the current situation already resembles the early 1980s. While fear is an incredibly powerful short-term market force, it, like gold bubbles, does not last forever. (Think the value of gold is unshakable? For more, see The Gold Standard Revisited.)